Surprise: Bonds Have Risks, Too

There was a time not too long ago when stocks were scary and bonds looked safe. Investors rushed into bonds, only to discover that fixed-income investments can be risky, too.

Complaints regarding brokers and bonds shot up. Last year arbitration cases involving corporate bonds rose to 353. That’s a fraction of the several thousand arbitration cases over stocks and mutual funds last year, but more than double the number of bond cases in 2001, according to the National Association of Securities Dealers, which regulates its member brokerages.

Though bond arbitration cases have since abated–204 cases are projected for this year–this might just be the calm before the next storm. If interest rates rise over the next year or so and bond prices fall, complaints again will spike, securities experts predict.

“The interest rate environment is a ticking time bomb,” said Andrew Stoltmann, a securities lawyer in Chicago who handles arbitration cases.

A survey by the NASD found that 60 percent of investors don’t understand that when interest rates go up, the price of existing bonds falls. That’s even true of U.S. government-backed bonds. To head off a potential problem, the NASD issued a notice in April to brokerages, reminding them to disclose the risks of bonds to investors.

But there is another reason besides rising rates to be concerned.

Bonds New for Many Boomers

The oldest Baby Boomers turn 59 next year, and as they near retirement they will shift more money from stocks into bonds. Many Boomers will be new to bonds and could get burned, not knowing what they are buying or what to ask.

To avoid a scorching, it helps to understand some basics.

– Bonds are IOUs. When you buy a bond, you are lending money to a company or government. In return, you receive interest. When the bond matures, you get your original investment back. Sell earlier, and you will get the market price, which may be more or less than you paid, depending on where interest rates are at the time and the perceived creditworthiness of the issuer.

But unlike stocks, bond prices are far less transparent.

“In stocks, you can open up your newspaper and get yesterday’s stock trades and prices. It’s available online. It’s been like that for decades,” said Kevin Olson, founder of MunicipalBonds.com “We never had that on the bond side.”

Bond pricing is becoming demystified. Olson’s Web site, for example, has been posting municipal bond prices for five years, marking those in red when there’s a big difference in prices from the same issuer.

The NASD began posting online the price of some corporate bonds two years ago. Now prices on 19,000 bonds are listed with a 30-minute delay from the last trade here. Next year, transactions for all 23,000 corporate bonds will be displayed, and the reporting time will be cut in half.

“If they have pricing information, they can take a look to see if their broker is offering a reasonable price for the bond,” said John Gannon, vice president of NASD investor education.

Here are other bond features and risks:

– Markups, markdowns. Bonds are bought and sold through a brokerage trade with markups and markdowns, not commissions.

Typically, a brokerage will acquire a bond for one price and mark it up, say, 1 percent to 5 percent, when selling it to an investor. Because the markup is part of the bond’s price, it’s not obvious to investors.

Similarly, when a bond is sold, there’s a markdown, which is subtracted from the bond’s sale price before investors get the proceeds.

While there’s nothing wrong with charging markups and markdowns, their lack of clear disclosure leaves many people unaware that they are paying these charges or not knowing if they are getting the best deal. Check brokerage charges

Stoltmann, the Chicago securities lawyer and a former broker, said the big problem he sees in arbitration cases involve frequent trading of clients’ bonds to generate income for the brokerage and broker.

Some brokers, Stoltmann said, are buying long-term bonds for clients, which generally have a larger markup. After a short time, the brokers convince these investors to sell the bonds and buy new ones, thus generating markups and markdowns, he said.

– Interest rates. The relationship between rising rates and bond prices works like this: As new bonds come on the market offering higher rates, an older bond with a lower rate is less desirable. If that bond is sold before maturity, an investor will have to sell it at a discount to attract a buyer.

Conversely, if rates fall, an old bond paying a higher rate becomes more valuable and can command a higher price.

– Credit risk. Credit agencies rate the probability a bond issuer will default and investors won’t get their money back.

The 80 percent of small investors who want to buy and hold bonds should stick with AA or AAA bonds, said O’Brien. “They are the two highest rating categories, the two best,” he said.

High-yield bonds, or junk bonds, carry lower ratings. They reward investors for taking more risk by paying them a higher rate. If the company’s fortunes head south, bond investors could lose money.

Credit ratings are part of the dispute in the NASD’s complaint filed earlier this month against H&R Block Financial Advisors, owned by tax preparer giant H&R Block. The NASD charged the brokerage with fraud, claiming it pushed hundreds of customers into buying more than $16 million in Enron Corp. bonds in the weeks leading up to the company’s bankruptcy filing in December 2001. The NASD said the brokerage, among other things, failed to disclose to investors that some credit agencies had already downgraded Enron.

Block, denying any wrongdoing, maintains that the high-yield bonds still carried a top rating when they were sold.

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